10 November 2009

A virtual interview with the WSJ and the FT - Part 3

FT: There is a debate about whether we are in a deflationary or inflationary environment: what are your views on this?

:My answer is yes to both. It looks contradictory but it is not. It depends of the time frame you choose. Let me explain. Short term we are in a deflationary environment for three main reasons:
  1. Banks are deflating their balance sheets and rebuilding their equity leading to less credit available that is definitely deflationary. It is more profitable and less risky to invest in Treasuries instead of lending to businesses and consumers with a financing cost near zero.
  2. Unemployment is above 10% in the US (add 10% more for underemployed and unemployed so discouraged they are not even looking for jobs), and rising. Therefore there is no pressure on wages (to the contrary) and there is no example of a sustained inflation period without wage inflation.
  3. There have been a massive wealth destruction (housing, bear markets) that not only left many in an extremely difficult financial situation but also resulted in a real psychological shock for many more, the pensioner or soon to be retired not being the least. They have to rebuild their savings and regain confidence; it will take time. This will be detrimental to consumption.
If short term I do not see any inflation threat, longer term I do.

  1. The FED and the likes will do everything they can to avoid a deflationary spiral. Money will continue flowing. It is however not flowing to the real economy (at least in the Western world) but to risky (equities) and non-risky assets (Treasuries/fixed income). There is an apparent contradiction here, since the surge in equity markets imply a V shape recovery whilst bonds imply a U shape recovery. I will come back on this later.
  2. The long term rise of developing economies will again spur demand for commodities and energy. The pause we have witnessed with the current crisis is only temporary. In the meantime many exploration projects have been postponed or canceled due to diminishing demand and a move away from riskiest assets; due to the time frame to develop mines and wells to bring them to production (a couple of years), we will see a new rise in commodities that will dwarf the 2006-2008 one.
    This may even go beyond: China has taken advantage of the crisis to use its financial might to secure reserves all around the world and are better placed than the West (and Europe in particular): the access to commodities may add to price surge.
  3. The wage deflation (stricto sensu or via high unemployment) cannot carry for too long without having long term destructive effects on the economy: consumers need purchase power to consume.
  4. Inflation is the politically less painful way to pay down ballooning public debt.
Medium to long term money creation coupled to growth in the developing world will lead to inflation (I do not expect hyperinflation however). This will lead mainstream investors to add fund to hard assets. Before this comes watch the mother of all bubbles to deflate: fixed income instruments.

Going back to the apparent contradiction between equity and bond markets, I refer to an interesting paper written by PIMCO, the world largest fixed income manager. Two extracts summarize it:
Thus, while rich risk asset prices can certainly be viewed as a consensus expectation for a strong recovery, such lofty valuations can also be viewed as a consensus expectation about the Fed's commitment to erring on the side of being too late, rather than too early, in starting a Fed funds tightening cycle. Indeed, one could actually be agnostic, even antagonistic, about a big-V recovery and still be favorably disposed to risk assets, in the short run. Historically, what pounds risk asset prices is either a recession or unexpected Fed tightening; or worse, both. Right now, it is hard to get wrapped around the axle about recession, since we've just had one, which might not even be over.
In turn, a bull flattening bias of the Treasury curve, with longer-dated rates falling toward the near-zero Fed policy rate, can be viewed as a consensus view that the level of the output/unemployment gap plumbed during the recession is so great that disinflationary forces in goods and services prices, and perhaps even more important, wages, will be in train, even if growth surprises on the upside. Accordingly, Treasury players, like their equity brethren, need not fear the Fed, as there is no economic rationale for an early turn to a tightening process.
I totally subscribe t0 their conclusion (emphasis mine):
Simply put, big-V'ers should be wary of what they wish for. U'ers, meanwhile, must be mindful of just how bubbly risk asset valuations can get, as long as non-big-V data unfold, keeping the Fed friendly. But that's no reason, in our view, to chase risk assets from currently lofty valuations. To the contrary, the time has come to begin paring exposure to risk assets, and if their prices continue to rise, paring at an accelerated pace.


Federal Reserve Bank of St Louis

The Uncomfortable Dance Between V’ers and U’ers